This Slow Motion Junk Bond Default Getting Worse

Shale oil drillers need financing to keep pumping the oil. Typically they borrow from banks and issue bonds, which bonds are of the "junk" variety. They pay high interest on these bonds, relative to bonds issued by more established companies with higher credit ratings.

As the price of oil tanked, storm clouds gathered. With lower oil prices, shale companies earned less on the oil they produced. Since producing shale is relatively expensive, the lower oil price hit these companies faster and harder than companies who use more traditional drilling methods. And with the price of oil turning down again, after an extended bounce, we may now see some of the more dire predictions about credit defaults come true. Lenders are losing patience.

“Lenders in general are increasing pressure on oil companies either to raise more equity or do some sort of transaction to pay down their credit lines and free up extra cash,” said Jimmy Vallee, a partner in the energy mergers and acquisitions practice at law firm Paul Hastings LLP in Houston.

With the oil price trending down again, it now looks like some of the weaker companies will begin to default on their payments. The slow motion disaster that looked like it might not happen now looks more likely. And it's not the failure to make interest payments that should cause the biggest concern. After all, if a bank doesn't get paid, one assumes they've got other loans outstanding that do pay. Not that banks like waiting for their money, of course, but they typically are the first ones to get paid in the event a company approaches or declares bankruptcy. It's the bond holders who stand to take a beating. For example, here's what may happen to one company's bond holders:

In the event of a Halcon default, Standard & Poor’s estimates that unsecured bondholders would get, at most, 10 percent of the almost $2.6 billion they are owed. Banks have first dibs on most of the company’s assets. Other investors will get next to nothing.

And let's not forget that many of these bond holders are funds, whose investors have grown used to low default rates ever since the last financial blow-up in 2008. If investors become uneasy and start pulling money out of junk bond funds in sufficient numbers, an avalanche of sales may hit the dreaded wall of an illiquid market where sellers can't find buyers. To meet investors demands for redemptions, the fund may be forced to sell other bonds having nothing to do with the shale business at discounted prices. A negative feedback loop can rather quickly push prices further and further down across the whole junk spectrum.

This feared scenario didn't unfold after the first dramatic fall in the price of oil from around 100 down below 50. The corrective trend stopped it cold. But now that corrective trend may have ended. And so tough times loom not only for holders of shale oil company bonds, but holders of all junk bonds.

An even worse scenario exists where a rapid fall in junk bond prices causes hedge funds to unload to meet margin calls, since such funds commonly buy using leverage. But let's not go there now. That scenario could cause the spread of a credit crunch into all areas of the markets. Fortunately it's not gotten to that point - at least not yet.